In New Enterprise Associates 14 v. Rich, No. 2022-0406-JTL (Del. Ch. May 2, 2023), the plaintiffs (Plaintiffs) were a group of sophisticated venture capital firms that invested heavily in a start-up called Fugue, Inc. (the Company) starting in 2013. In mid-2020, Plaintiffs urged the Company to pursue a liquidity event, which prompted a sales process that ultimately failed. By the end of the first quarter of 2021, the Company’s CEO, Josh Stella, informed the Company’s board of directors (the Board) that the process had failed, the company needed capital, and the best option was to engage in a recapitalization led by Defendant George Rich (the Recapitalization). Rich’s terms for the Recapitalization included a requirement that twenty-nine key stockholders sign a voting agreement (the Voting Agreement). As relevant here, the Voting Agreement included a drag-along right, which:  (1) obligated all signatories to vote in favor of any transaction approved by the Board and a majority of the preferred stockholders (the participants in the Recapitalization) that meets a list of eight criteria, and (2) included a convent not to sue Rich, his affiliates, and his associates over any such sale. Plaintiffs agreed to the Recapitalization, declined to participate in it, and signed the Voting Agreement. The Recapitalization took place in April 2021.

A drag-along sale soon materialized. A potential acquiror contacted Stella in late June 2021, and negotiations began. Shortly thereafter, in mid-July, the two independent directors on the Board resigned, leaving only Rich, Stella, and David Rutchik, who had participated in the Recapitalization. A week later, the Board authorized the issuance of nearly 4 million additional shares of preferred stock at the same price and on the same terms as the Recapitalization, which were “extracted . . . when the Company was low on cash and had no alternatives.” Then, on July 29, 2021, the Board also approved grants of stock options, including large grants to themselves. Plaintiffs discovered these two transactions (the Interested Transactions) after reviewing a distribution waterfall circulated in connection with the closing of the sale in February 2022. Despite the fact that the merger met all eight criteria to constitute a drag-along sale, Plaintiffs had already refused to sign a joinder agreement and voting form in favor of the merger because Stella and Rich did not attest that they had not communicated with the acquirer regarding a potential transaction before the Recapitalization.

The discovery of the Interested Transactions prompted Plaintiffs to do what they had covenanted not to do in the Voting Agreement – sue over a drag-along sale. Plaintiffs asserted, among other things, that the Interested Transactions involved obvious self-dealing on terms unfair to the Company but highly favorable to Rich, Stella, Rutchik, and their associates, and therefore constituted breaches of the fiduciary duty of loyalty. Plaintiffs alleged that the approval of the drag-along sale also was a breach of fiduciary duty because it extinguished sell-side stockholders’ standing to pursue breach of fiduciary duty claims based on the Interested Transactions and because it failed to provide consideration for those fiduciary duty claims. The defendants, which include Rich, Stella, and Rutchik, moved to dismiss the action, asserting, among other things, that the covenant not to sue in the Voting Agreement bars Plaintiff’s claims. 

The Court of Chancery, having denied the motion to dismiss for failure to state a claim on other grounds, evaluated the covenant not to sue in its May 2, 2023 decision. Plaintiffs argued that the covenant is facially invalid because Delaware law does not allow parties to waive fiduciary duties except in the limited circumstances set forth in Sections 102(b)(7) and 122(17) of the Delaware General Corporate Law (DGCL). They did not argue that it was induced by fraud or overreaching or that they did not understand it or its implications when they signed the Voting Agreement—in fact, the covenant was based on a model provision sponsored by the NVCA, an organization of which one of the plaintiffs is a member. The court rejected Plaintiffs’ argument as overly absolutist, saying that it failed to account for a variety of permissible forms of fiduciary tailoring, ignored the difference between attempts to limit fiduciary duties in the constitutive documents of an entity and an agreement to do so in a stockholder-level agreement, and failed to pay heed to the importance of private ordering in Delaware law.

Vice Chancellor Laster explained that, contrary to Plaintiffs’ bright-line proposition, Delaware law has long allowed fiduciary obligations in the trust and agency contexts to be modified by contracts including narrow purpose clauses or provisions specifically authorizing conduct that would otherwise constitute a breach of loyalty. And Delaware’s corporate law has accommodated these traditional forms of fiduciary tailoring in addition to explicitly allowing certain types of fiduciary tailoring or limitations on fiduciary accountability in §§ 102(b)(7), 122(17), 102(a)(3), 141(a), 145, 327, and 367 of the DGCL as well as in various common law doctrines. In particular, § 122(17), which authorizes advance renunciation of corporate opportunities, and the common law doctrine allowing stockholders to ratify certain interested transactions in advance both resemble traditional fiduciary tailoring by authorizing conduct that would otherwise constitutes a breach.

VC Laster also emphasized the contractarian nature of Delaware law and the overall philosophy that sophisticated parties “can and should ‘make their own judgments about the risk they should bear.’” This commitment “should be at its height when stockholders enter into agreements about how they will exercise stockholder-level rights.”  Those rights, which include the rights to sell, to vote, and to sue, are the personal property of the stockholder, so the stockholders are free to contract over each of the rights.  And, in the context of a voting agreement like the one at issue here, the stockholders have explicitly consented to the limitations on their rights. These considerations weighed heavily in favor of finding the covenant to be valid. 

The Court also raised and rejected four additional arguments

• The court dismissed the argument that breach of fiduciary duty is too big to waive by pointing out that Delaware law allows individuals to waive even more fundamental rights such as the right to trial by jury and the right to counsel in a criminal case, as well as statutory rights associated with property ownership, employment, and the right to speak freely.

• The court considered the argument that the guarantee of certain immutable, standard fiduciary rights was essential to Delaware’s corporate brand, but held that private ordering, especially by means of a stockholder-level agreement, is also a fundamental component of Delaware’s corporate brand.

• The court rejected the slippery slope argument that allowing the covenant and similar waivers of fiduciary claims would collapse the distinction between corporations and LLCs because the distinctions exist at the constitutive document and governing statute level and are not affected by a stockholder-level agreement.

• The court reviewed the Delaware Supreme Court’s decisions in Manti Holdings, LLC v. Authentix Acquisition Co., 261 A.3d 1199 (Del. 2021), a case involving a covenant not to assert appraisal rights, to anticipate how that court might approach this issue. Vice Chancellor Laster concluded that, under Manti’s framework, a broad, unspecified waiver of fiduciary duties or a covenant to never assert claims for breach of fiduciary duty regardless of facts might be facially invalid, but a covenant like the one at issue, which appeared in a contract that was bargained-for, involved counsel, and was signed by sophisticated stockholders who understood the covenant and its consequences, is not facially invalid.

The Court ultimately concluded that a provision like the covenant should be analyzed in two steps. First, the provision must be narrowly tailored to address a specific transaction.  Second, it must survive close scrutiny for reasonableness. The covenant at issue passed both tests—it applied to only transactions that meet eight specific criteria and, as described above, it is reasonable to enforce it against the sophisticated stockholders who signed the Voting Agreement.  

Before simply enforcing the covenant and dismissing the case, however, the Court raised one final issue—Delaware’s public policy against contracts that attempt to exculpate parties for fraudulent or bad faith acts. According to this policy, the covenant is invalid to the extent that it seeks to prevent assertions of claims for intentional or bad faith breach of fiduciary duty. Given the self-dealing alleged in the complaint, the covenant was not a bar to claims in this case.